Accounting is responsible for capturing all types of transactions in a company. Depreciation is an expense that relates to a company’s fixed assets. It is important because depreciation expense represents the use of assets each accounting period. Many different types of assets can incur depreciation. Facilities, vehicles and equipment are among the most common assets depreciated.
Depreciation represents the specific use of a company’s assets in an accounting period. When companies make large purchases, they will record the items as assets. Assets represent long-term value for a company’s facilities, vehicles and equipment. Expensing these items when purchased would create distorted net income. Therefore, accounting principles prefer that these items be recorded as assets with a corresponding expense recorded when the company uses each item.
Many different depreciation methods are available for use in accounting. Basic elements for these items include historical cost, salvage value and useful life. Companies will often subtract the salvage value — the money gained when selling the asset — from the historical cost. Using the straight-line depreciation method, accountants divide this figure by the asset’s useful life. This represents the annual expense for using the asset.
Companies use depreciation to report asset use to stakeholders. Deprecation also reduces the historical value of assets. Stakeholders can review this information and know when to expect replacement assets purchased by a company. For example, a company with production equipment will often replace these items at some time during its operations. When accumulated depreciation nears the asset’s historical cost, a replacement purchase may be coming up soon.
Tax benefits are also possible with depreciation. Although depreciation represents a non-cash expense on the income statement, it does reduce a company’s net income. Lower net income will incur a smaller tax liability. To maximize this benefit, companies will often use an accelerated depreciation method. The Internal Revenue Service provides companies with an accelerated depreciation method for different asset classes. This allows for more depreciation early on with assets and lower initial tax liabilities.